1/1/09 -

On 12/31/08 the S&P 500 closed at 903, resulting in a total return of -37% for the year. We are invested for income. This recession promises to be severe, as it has been exacerbated by a seized up credit system both in the U.S. and abroad. It is like no other since the 1930s.

Market Analysis

The U.S. stock market finally followed economic events downwards. Although it is somewhat easier to spot the market peaks, it is more difficult (and in this case impossible) to spot the market bottoms because stock market prices will depend upon the effects of large-scale government intervention as well as the willingness of financial companies to do business with each other and to lend to the real economy.

Reason

Commercial banking is not a complicated business, matching saving with borrowing. But a deeply compromised credit rating system enabled the introduction of complex, ill understood, and mismanaged structured financings directly into the heart of the banking system. The 7/07 collapse of two Bear Stearns hedge funds brought into the question the statistical conventions that Wall Street used to price these fundamentally unsound loans and their derivatives. More than a year later, the credit (liquidity) generating commercial banks ceased to trust each other, their balance sheets afflicted with questionable assets, seizing up the world’s financial system.

On 12/17/08, Bloomberg estimated that total world-wide financial writeoffs to date surpass $1 trillion, with U.S. firms’ losses totaling $678 billion. This hit to the roughly $1.7 trillion leveraged net worth^* of the large U.S. financial institutions is massive, explaining the large $700 billion likely TARP treasury recapitalizations of the banking system. That has to happen.

Implications

Massive government interventions: recapitalizing the banking system, addressing the housing crisis; and stimulating the economy will prevent an economic collapse. But we cannot specify the timing and magnitude of their effects.

But government cannot, by itself, produce long-term economic growth. To draw a rather imperfect analogy. In 1989, the socialist system of the Soviet Union disintegrated, a system that allocated capital according to the Five-Year Plan. This economic system was able to build infrastructure and heavy industry; but it failed to build a modern economy, comprising the more sophisticated services and light manufacturing that the Plan could not envision or implement.

A functioning market system is necessary for economic growth. Under normal circumstances, the Fed’s interest rate decreases will initiate a Keynesian portfolio adjustment process, forcing investors in search of profits into riskier assets such as corporate bonds and stocks, thus reducing the cost of capital. Interest rate decreases initiate adjustments in the capital markets that encourage real economic growth. But the events of seized up credit markets and the continued drumbeat of bad news, particularly house price declines and debt defaults, are increasing perceived risk and inhibiting the banks and investors from taking on more. In specific, the 12/26/08 WSJ reports that the current economic slump has battered small business credit. These companies created 60-80% of the new jobs in the last decade and were responsible for more than half of the nation’s non-farm private GDP. Merely sunny market forecasts will not make the credit problems go away.

New government programs and appropriate regulations will eventually make the financial system more predictable; we also expect they will encourage economic growth from the private sector, over the long-term. The real comparative advantage of the U.S. economy should be scientific innovation, improving productivity; and entrepreneurship, taking intelligent risks.

Portfolio Strategy

The return of a stock:

Annual Return    =    Dividend Yield     +      Growth Rate in Dividends ^**
(it should  be secure)                     (in time)

In this complex economic environment, we are simply emphasizing current dividends and a valuation margin of safety; expecting that economic growth will occur in the future.

^* Net worth calculated from 12/07 data. 

^** This model states dividend growth also determines investment return, in the long run when business fundamentals matter. Bogle (2009, pp. 51, 49) writes, “In the short run, investment returns are only tenuously linked with speculative returns (our note: the impact of current events upon expectations). But in the long run, both returns must be – and will be – identical… Investing is all about the long-term ownership of businesses. Business focuses on the gradual accumulation of intrinsic value, derived from the ability of our publicly owned corporations to produce the goods and services that our consumers and savers demand…”

We will discuss our error correcting model of the S&P 500 when credit has been restored to both the domestic and international economies.

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We do not expect much additional bank lending from the treasury's TARP recapitalizations. Alan Blinder, former Fed vice-Chairman (Bloomberg, 1/7/09), says that the banks are in a state of "catatonic fear." The treasury has so far allocated $250 billion to buy bank non-voting preferred stock and $93 billion in other financial support. However consumer lending, as of October, continues to drop; and the Fed reported that 85% of all banks have tightened commercial loan standards. This happens after a credit binge, when the banks suddenly rediscover religion and bona-fide opportunities to lend decrease anyway during a recession.

At this point additional funds will have to come from fiscal policy, the necessary bills will have to wend their way through Congress, and direct Fed asset purchases. Due to its inflexibility, fiscal policy is not the preferred tool for financial stimulus; but the effects of interest rate decreases have obviously been minimal - as Keynes predicted when the economy confronts a liquidity trap. Through several major programs the Fed is also supplying credit directly to the private economy, making loan and securities purchases, bypassing for a while the banking system.

1/15/09 - Is this form of analysis useful? Does it try to answer the stock market unanswerable? You judge. Caution: A short-term analysis, not a value analysis. Might be useful for hedging.

What might the Financial Crisis of 2008 have upon the U.S. economy? The following paper considers this issue quantitatively; we then factor in purely qualitative issues concerning the U.S. stock market. We use both types of reasoning to get an idea (of course imprecise) of how the stock market might behave in the near future. We have, as a result, slightly hedged our portfolio that is invested for value and dividend yield.

Reinhart and Rogoff ((2008), from the University of Maryland and Harvard respectively, presented a paper titled “The Aftermath of Financial Crises.” The authors studied 21 systematic banking crises in both the developed markets (18) and in the emerging markets (3); Asia, Colombia, and Argentina. Analyzing the data, they found that “banking crises in rich countries and emerging markets have a surprising amount in common,” across time and countries. We summarize their results and note the S&P 500 for this market cycle:

Average Change % Average Years

(peak to trough)

GDP -9.3 1.9

House Prices -35.5 6.0

Unemployment * +7.0 4.8

Stock Market -55.9 3.4

S&P 500 ** -51.9 1.1

*   Trough to Peak

** S&P 500 on 10/09/07 1565

 S&P 500 on 11/20/08 752

This analysis is useful although it uses the average (mean) to estimate the maximum likelihood of assuredly non-Gaussian data. In each case, however, the average is more-or-less in the middle of the data distribution and is likely to be a somewhat representative description. The table above suggests that the stock market lows might have already occurred on 11/20/08, and that this occurred early in the downturn.

Economics deals with the repetitions, and history deals with the unique. All crises are, to an extent, unique; we modify the analysis above by the following qualitative factors that we think matter for this stock market, estimated on a scale of (1-10).

(+) The U.S. can reduce the effects of this downturn by more government spending. (4)

(-) The U.S. dollar is at the center of the international system of payments and trade credit; this crisis is affecting the international financial system and trade. (10)

Considering the net negative of these qualitative factors, we think it possible that the stock market could drop below its previous 11/20/08 low of 752. Since this is about investment, rather than trading, we have only slightly hedged our portfolio. The paper suggests lasting effects of this economic crisis and lots of necessary government debt.

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This discussion has concerned some of our readers (we rephrased this sentence). Warren Buffet suggests the main criterion for buying a stock in a 1/09 PBS interview. "When you paid a price for the stock, did you get your money's worth (at the time)?" However we will discuss the kind of analysis above from time to time, due to our curiosity about the stock market's short-term behavior.

2/1/09 -

The S&P 500 closed at 826. President Obama was inaugurated on January 20th, bringing the prospect for better governance. The stock market promptly tumbled by 5.3% on that day. The problem is the severity of the present banking crisis. Normally a financial economist would make the assumption, that in markets, y = E(x); in fact what is happening is that y = x. Long-term expectations have disappeared as the mind of the market is again suddenly concentrated on its banking problems.

At the core of the stock market’s problem is the banking crisis and the restriction of credit. An initial cause was the housing crisis. Credit was too easily available and borrowers overborrowed; the resulting loans were placed into structured financings whose values plummeted. There are many solutions mentioned to the banking crisis. But as long as the housing crisis is not directly addressed, bank asset values will continue to erode; and their financial problems will continue. The housing and now banking problems have to be directly addressed and very soon, as they are pulling down the rest of the economy.

Government is trying all sorts of measures to get credit restarted, but only with some success. The financial system’s collective lack of lending is turning good credits into bad ones, but the solution is not to press the banks to lend more into declining markets. The more effective government actions would have to be very extensive: restructure those problem mortgages, get toxic assets entirely out of a recapitalized banking system, and make direct investments in the economy to create initial demand. Research cited in Rochet (2008) finds that it is very expensive to resolve bank crises in developed economies.What should result are sound bank balance sheets and lending cultures.

What about the likely future? A cycle has to occur in the economy, leading to the restart of private sector credit and -most important- the restoration of trust. That will take time; reality just is. Government will determine more social priorities* and improve regulation; the private economy has grown by commercializing the technological innovations that keep the U.S. competitive.

* Education, science, infrastructure, and health care. A 2/1/09 NYT magazine article notes that private sector investment was equal to 17% of the economy 50 years ago and is still around 17% (before this crisis). Investment spending by government has dropped from about 7% of GDP in the 1950s to around 4% now. The Obama administration considers this a chance to reshape the economy. We note also what market forces working with government policy can do. After any large market drop, sector rotation will result in the stocks of some company laggards turning into leaders, and vice-versa. In this case, long-term government investment should eventually result in profit growth in the above industries and the economy. The Times article also points out, "...the defeated countries of World War II didn't rise in spite of crisis. They rose because of it."

2/17/09 – Contrast this discussion with the one of 1/15/09. The following analysis deals with exactly the same issues as our earlier analysis, except it deals with the more tractable concrete events in markets, events that investors with the value philosophy call “catalysts.” In this case, we identify negative catalysts in the economic system that need to be dealt with pragmatically.

We have further reduced our equity asset allocation, reversing in part our 11/05/09 increase. Although many blue-chip stocks have reached value levels that we thought impossible a couple of years ago, the macro environment is still highly problematic. We heard some investment managers speak; they expressed the hope that the economy might stabilize towards the end of this year; but they are not happy. We draw two additional inferences from what was discussed:

1. Government response has so far been hesitant because this crisis is new both to government and investors. Crisis remediation is no longer a simple matter of pursuing an appropriate monetary policy. But fiscal policy cannot fine-tune the economy; its effects are likely to be unpredictable.

2. Credit created by the banks is subject to a finite multiplier effect,

as the textbooks state. This credit crisis has been created by a general deleveraging of both the foreign and domestic economies, where decreasing dollar trade deficits and securitizations have a (theoretically) infinite multiplier effect in reverse.

Governments around the world are opening the monetary taps to replace both kinds of credit; that should have a positive effect on activity. But the path towards sustained growth is likely to be very lumpy and fraught with the press of political events. Furthermore, our analysis of the behavior of the S&P during the 1930s indicates that, surprisingly, investors simply followed earnings (that effectively dropped to zero in 1932) down and then up (with different regression slopes).

We once analyzed the credit of a European bank in the midst of a previous financial crisis. We wondered, what if that bank went down? The common sense response was, “If that bank goes down, we’re all in trouble.” The next year or so will test the system and investors,. Our next essay is, “What Happened?” We try to describe this complex crisis simply.

3/1/09 -

The S&P 500 closed at 735. This financial crisis is a crisis of both the credit markets (formerly about 70-75% of total credit) and of the banking system. The Fed is undertaking measures to restore the credit markets by direct lending.

But there is a major problem with the banks that supply a bundle of very necessary depository and payments services, in addition to credit. As the situation now stands, they are too big to fail and even too big to formally nationalize without major disruptions. There are two modes of thought regarding this problem: 1) According to a recent G-30 report chaired by Paul Volker, the entire financial system, having suffered a “severe breakdown,” should be reformed by simplifying the credit-generating banks. More complicated, deal-oriented capital market activities should be left to other financial companies. What should emerge in the U.S. (again) is a Glass-Steagall like division between highly regulated commercial banking and the rest of finance. * 2) William Issac, former chairman of the FDIC, suggests muddling through with existing management and government support.

As this financial crisis drags on, muddling through with banks that cannot lend is not an effective option. De facto nationalization of the banking system, at least for a while, is occurring. Citigroup, setting the precedent, is presently funded with treasury owned preferred stock, convertible depending upon circumstances into common. Some directors of the bank have left, to be replaced by government approved ones. The financial system is essentially one big loan workout. Consider this footnote (5a). The result will be simpler investments and a simpler financial system. To state the obvious, Adam Smith’s invisible hand of the market has fumbled badly and now governments must assist to restore the state of credit, but this time on a massive scale.

Congress passed a $827 billion stimulus package. For that to be effective, there must also be a viable financial system and a solution to the housing crisis. The Administration is addressing all three areas, intending to continue its efforts until the economy begins to recover. But, to cut to the chase, the stock market will likely increase only when earnings do. This suggests continued caution and a conservative investment policy, appropriate for the times.

* The financial conglomerates may have become almost unmanageable by their managements and their regulators; noting A.I.G., Citigroup, and Merrill.

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How did investors react to earnings in the 1930s? Why do investors invest in stocks? The following analysis supercedes our earlier observations that during periods of crises, investors react only to the present. In the 1930s, investors (surprisingly) reacted both to the present (as a starting point) and to the future they optimistically expected. Read on for a discussion of market behavior and of the present economic situation.

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So what to do about the banking system? In the 3/8/09 NYT, Alan Blinder former Fed Vice-Chairman writes, contrary to the Swedish model, the formal nationalization of banks in the United States is too daunting for anyone to undertake. The best solution is the good bank, bad bank approach. Here’s the deal. Break the sick institution into two, hiving off the good assets into a viable bank that can be recapitalized in the markets and the leaving the bad assets to be financed by guess who? The taxpayer. There is really no choice; as we mentioned earlier, the recapitalization of the banking system is going to be very, very expensive. The result, when combined with Mr. Volker’s suggestion, will be sound banks that can lend money to the economy. Time to press the reset button.

Large scale banking goes all the way back to Florence, Italy during the Renaissance with the de’Medicis. Banking is really a rather simple business, built upon trust. The advantage of the above suggestions is that they directly address the issue of trust in the financial system and its financings.

3/16/09 –

Despite the recent market rally to 756, with the implication that the worst is behind *, we think that quite a few economic problems remain unresolved. In a 3/13/09 interview on PBS, Harvard economist Kenneth Rogoff (cited 1/15/09) said that the Administration is in denial, hoping the problems will go away. He then cited the following: roughly $2 trillion required to recapitalize the U.S. banking system - a reasonable estimate - and U.S. government debt must increase, possibly another $8-9 trillion over the next few years.

The political reaction in the U.S. to massive economic problems has been incremental. The Republicans prefer a market solution, neglecting the problems that TARP had with valuing toxic bank assets in the first place. Opening up the valuation process up to private bidding, with government leverage and guarantee assistance, will simply result in the banks’ portfolios being cherry picked for the best assets, with the worst still on their balance sheets. This process could take years. Knowing that greater government action is necessary, the Administration asks for patience, while the back-loaded stimulus program becomes effective.

Are these incremental approaches enough? We point out the present crisis is a crisis of markets, and markets can react with breathtaking speed – as has been demonstrated. 1) U.S. GDP has dropped at an estimated annual rate of 5.6% since the end of the third quarter last year. 2) Japan’s exports have dropped by 46% (sic) in January alone since U.S. importers cannot get bank letters of credit. Foreign sales during 2007 constituted 46% of all S&P 500 sales. 3) But a 3/15/09 G-20 meeting has not reached a consensus on the necessity of more fiscal stimulus, despite U.S. pressure.

The present barriers to more than incremental approaches to this crisis are political. There is no consensus in Congress for bailing out the banks past around $300 billion so far spent under TARP, and Congress is loath to increase the deficit. A consensus has to develop in Washington that further actions have to be taken.

* This market rally was sparked by Citigroup’s memo that the bank was profitable in the first two months of this year on an operating basis, if you neglect further asset writedowns. The 3/16/09 NYT presents a calculation that encapsulates what is happening at B of A, the nation’s largest bank: $50 billion in annualized profit before taxes and provisions; balance sheet $2.4 trillion; annualized profit around 2% that can be used to write off further losses without reducing reported 2008 Tier I capital of 10.7%.

If you assume that the bank’s net worth is highly compromised, and the bank’s $6 stock price says essentially that despite a recent 86% rally (B of A’s book value is around $28/share), then there can be no expansion of the balance sheet with additional lending - for five years? No modern economy can let this situation continue. In a recent interview, Fed chairman Ben Bernanke said that before the economy can grow again, the financial system has to be stabilized.

4/1/09 –

On 3/18/09 the Fed announced a new $1.25 trillion program to increase credit to the economy by purchasing $300 billion in treasury securities and increasing its purchases of mortgage-backed securities. This large credit market intervention motivates a more general analysis of the Fed’s impact on the economy.

Since December, 2007 the Fed has announced total guarantee and credit programs totaling $12.85 trillion, including the above. Of that amount, around $9.84 trillion is for programs that provide credit directly to the economy. The amount of this credit drawn to date has been $1.66 trillion. That leaves a large $8.18 trillion in credit yet to be supplied. Divided, say over the next two years, the Fed has the potential to supply a massive $4.09 trillion in credit/year directly to the economy, or 29% of 2008 GDP/ year. This will replace private securitizations, bond issues, and bank credit.

From Securities Industries and Financial Markets Association data, we calculate* that from a $2.34 trillion peak in 2006, U.S. securitizations dropped to only $545 billion in 2008 on an annualized basis, a drop of $1.8 trillion. These securitizations are important (in 2008 total U.S. GDP was around $14 trillion) now add to that decreases in bank credit and new bond issues. Planned Fed credit actions over the next two years will probably just offset the decrease in private sector lending, absent any multiplier effects.

What is going to be the impact of a Fed credit policy of this magnitude? It will, in the short run, avert a large collapse of GDP; but will Fed policy kick-start the economy? Without a functioning banking or securitization system to create additional credit and therefore a multiplier effect, it won’t. The money after supporting house prices or funding infrastructure will end up in bank demand deposits and excess bank reserves held at the Fed, and that will be that. ** If credit does not flow back to the economy in the form of loans, the U.S. will enter an era of economic stagnation and higher public debt, as did Japan.

Quite aware of this, but mindful also of the unwillingness of Congress to “bail out the banks” (that is to recapitalize them so they can lend again), the Treasury has announced the use of public and private capital to buy up toxic assets within created markets. But this does not address the insolvency (to be frank) of the U.S. banking system, a question only Congress can and must address.

There is an 800 pound gorilla in the room named “Credit.” Its easier and necessary to restore the securitization markets. Restoring the banking system is going to be politically much more difficult, and very necessary. Then there is the problem of the international economy that in 2007 accounted for 46% of the S&P 500’s sales; actual exports accounted for around 11% of U.S. GDP.*** We are in uncharted seas and would be very careful. If the government can fix the credit system, we would say that the risks of stock investment will reduce to those typical of a very severe recession.

* We assumed that U.S. securitizations equaled total global securitizations less european securitizations.

** A 3/21/09 CNN article quoted World Bank President, Robert Zoellick who described this situation graphically. “Two of the world’s largest economies, the United States and China, are struggling with recession and have recently implemented stimulus packages worth hundreds of billions of dollars. However, Zoellick likened such stimulus plans to a ‘sugar high,’ saying they would likely lead to another crash. The issue now that is the most important are bad assets, and capitalizing the banks, ‘…The reason I use ‘sugar high’ is that its like if you have a stimulus, it gives you a boost, but unless you get the credit system working again, it will drop off.’”

*** According to the 2/15/09 Reuters, U.S. exports were only 5% of GDP in 1929. In spite of the Smoot-Hawley tariff of 1930, the course of the Great Depression was determined primarily by events occurring within the economy. In 2009, the U.S. economy is more influenced by the course of foreign trade; but aside from S&P 500 sales, the course of the macroeconomy will again mainly be determined by domestic events – provided the U.S. can continue to finance its trade deficits abroad.

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The Treasury has unveiled a plan to create a systematic risk regulator for the entire financial system. This presumes the omniscience of that risk regulator (or process) and of any future president, to nip financial market speculation in the bud, like the SEC and the former Administration didn't do. To finance future economic growth, the financial system should not have to depend upon the omniscience of regulators * and, as a matter of fact, on that of future bank presidents. It makes a lot more systems sense to have the banks do what they used to do under Glass-Steagall, make relatively simple loans in a more regulated environment. Deal-oriented activities such as investment banking, proprietary trading, complex hedging, and other financially creative activities ought to be hived off to separate and smaller firms that will succeed or fail according to their acumen, without endangering the rest of the economy.

The present system of large universal banks is too dependent upon fallible humans not to make investment mistakes. In the 3/2/09 issue, Time magazine performed a capital test on the four largest U.S. banks, using the loan loss estimates of NYU professor Nouriel Roubini. Only one bank passed that test of having the minimum amount of capital acceptable to regulators. The estimated capital writedowns at all these banks was massive. At two banks, management fell into simple value traps, buying distressed financial firms at prices they thought were bargains.

* According to a 3/27/09 Washington Post columnist, London had a unified financial regulator that “failed miserably.” They also probably didn’t understand the Gaussian Copula.

4/8/09 – n.b.

From a S&P level of 676 on 3/9/09 to 857 at present, the stock market has rallied by 26.8%. The crucial question to ask is whether this is a rally in a bear market or whether it results from successfully, as the WSJ put it, “Betting that a recovery will start later this year, (investors) were buying oil futures, industrial commodities, technology stocks and junk bonds, investment they shunned just a few weeks ago.” A portfolio manager recited, “You’ve got to skate to where the hockey puck isn’t.”

Compared to the relative order of a hockey match, Mr. Market is disorderly; but, as Benjamin Graham said, the stock market eventually reflects reality. For unleveraged investors that reality is ultimately earnings per share at the time; with less exactitude under normal conditions, as we have shown in “How the Stock Market Works,” and with more exactitude in the 1930s. If present market expectations of an economic upturn are not met in the second half of this year, the recent increase in the S&P 500 will have proved to be a rally in a bear market. Obviously, your evaluation time horizon matters.

The following suggests continued problems over the longer term:

Loans and Leases in Bank Credit (Federal Reserve Call Report, Seasonally Adjusted, add: Including Allowance for Loan and Lease Losses)

Recession Event Peak to Trough

1973 - .66%

1980 - .58%

1990 -1.15%

2001 - .39%

2008 -2.78% (10/31/08-3/25/09 rev)

The current drop in bank lending is very large; add to that the disappearance of the securitization market. According to 4/20/09 Business Week figures, the amount of asset based securities sold this year to date dropped by (sic) 98.2%. To state the all too obvious, without credit the economy won’t grow.

Large Unemployment Increases

In March, the U.S. economy lost 663,000 jobs resulting in an unemployment rate of 8.5%. The maximum six month loss was 3.7MM jobs, compared to a 2001-2 maximum loss of 1.3MM. This is no mere cyclical downturn; jobs were lost in all areas of the economy except one.

Trend in House Prices

Case/Schiller for January reports that year on year house prices declined 19%. On a month-to-month basis, the 20 City composite declined by –2.5%, one of the factors that led to the present stock market rally because many previous monthly declines were worse.

The first two are normally lagging indicators of economic activity. However, large declines reinforce each other, absent government intervention to keep things from getting really bad. This economic crisis is, at the root, a banking crisis. We are very cautious about the stock market because of the continued decline in housing prices and the large financial reforms that have yet to occur. We cite just two line items from a money center bank’s 2008 financial report to illustrate the problem the banking system still faces:

12/31/08 Book Shareholders’ equity $141,630 million

Other assets $165,272 million *

*12/31/05 balance: $80,456 million

“Other assets includes, among other items, loans held-for-sale,

deferred tax assets, equity-method investments, interest and fees

receivable, premises and equipment, end-user derivatives in a

net receivable positions, repossessed assets, and other receivables.”

How can investors proceed? It would be a good idea to pay attention to what is happening in Washington that is trying to restart the financial markets. The administration’s approach to the economy has so far been incremental. Thomas Friedman writes in a 4/5/09 NYT article, Phase I interlocks Federal Reserve and fiscal policies to “confine this economic crisis to a really nasty recession.” Phase II, and Friedman says there will be this phase, involves bailing out the banks with hundreds of billions, or possibly, a trillion dollars – depending upon economic conditions at the time. That will require a strong political consensus in Washington.

We would have liked the banking problem to be dealt with first; but the political process, for some reason, is not always logical. We will begin to slowly invest in equities (actually unhedge our stocks) when the stock market reaches rather lower levels, and then proceed in larger increments when the banks are recapitalized.

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George Magnus of UBS wrote in The Times of London, “Bank recapitalisation, asset purchase and guarantee schemes, and fiscal measures have all been deployed, amounting to 40 to 50 per cent of GDP in the UK and the US, and 15-20 per cent of GDP in the eurozone….The size of losses and bad assets is so large that it is barely conceivable that banks’ balance sheets can be repaired properly as things stand. Governments are committing taxpayers to huge costs (and future taxes) while many large banks are at risk of becoming the zombie institutions we said that we would never copy Japan in creating. The US and UK plans to deal with bad assets might work in a typical downturn, but in this recession, the chances are not good.”

In the past downturns, the Fed and the FDIC dealt with problems at single financial institutions add: or in a restricted sector of the financial system. The problem of bank solvency is now wide and systemic, requiring far more than incremental measures.

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To update the table above, from (10/31/08- 4/8/09) loans and leases on bank credit dropped further to 3.13%, a massive decline. The 4/19/09 Economist points out, “Financial crises can drag on because efficient remedies are politically unpalatable.” What governments in Japan, South Korea, and Sweden found out is that bank bailouts are very politically unpopular, therefore the U.S. Treasury underpriced insurance for bank assets rather than to overpay for them. There are, in the words of the article, “real-world political and legal obstacles” to the more direct approach of recapitalizing the banks. Paul Krugman asks, “Is it possible to engineer a durable recovery with fiscal expansion, or are you just buying time?” We think it’s the latter.

Just as a note with ideological implications; a reliance upon monetary policy - for which bank recapitalization is necessary - expands the private sector and a reliance upon fiscal policy expands the government sector. In other words, for the economy to grow again, bank recapitalization is a necessity.

5/1/09 –

The financial crisis of 2008-2009 is not like any other. Previous crises were caused either by excess inventories, as during the downturn of 2001, or by restrictive central bank monetary policies, as effectively occurred during the Great Depression. The 4/23/09 Economist calls this economic downturn a “balance sheet recession,” caused both by overleveraging and, as another author put it, by “worse than useless projects.”

The following seeks to answer two questions, “How long will this crisis last?” and “What are the implications of this for investors? The following does not support the “green shoots of recovery” hypothesis.

The major cost to society of banking crises is not the fiscal cost of bailing out the banks; from a societal standpoint, that involves only the transfer of income from the taxpayers to the banks. The major cost is the economic output lost to the entire economy for its duration. In a tightly reasoned study, Hoggarth, Reis, and Saporta (2001) of the Bank of England or Harvard University analyze, “Costs of banking system instability: some empirical evidence.” The authors studied 47 banking crises since 1974 in both high-income and lower-income countries with the following results that we excerpt:

Table C: Accumulated output losses incurred during banking crises

High-income countries Date of crisis Duration ^(a) GAP2 ^(c) Currency Crisis as well

(years) ____________________________________________________________________

Australia 1989-90 2 -1.4 No

Canada 1983-85 3 -10.5 No

Denmark 1987-92 6 31.9 No

Finland (1) 1991-93 3 44.9 Yes

France 1994-95 2 0.7 No

Hong Kong 1982-83 2 9.8 No

Hong Kong 1983-86 4 4.3 No

Hong Kong 1998 1 9.0 No

Italy 1990-95 6 24.6 Yes

Japan 1992-98 7 71.7 No

Korea 1997 12.8 Yes

New Zealand 1987-90 4 16.3 No

Norway 1988-92 5 27.1 No

Spain 1977-85 9 122.2 Yes

Sweden 1991 1 3.8 Yes

United Kingdom 1974-76 3 26.5 No

United States 1984-91 8 -41.9 No

_____________________________________________________________________

Average 4.1 20.7

(1) Boldface type indicates an insolvent banking system.

(a) Caprio and Klingebiel (1999) definition of a crisis.

(c) The cumulative difference between the (3 year) trend and actual levels of output during the crisis period.

This table contains several items of interest. First, the average duration of banking crises in developed countries is around 4 years. This data is very consistent with the peak-to-trough data in the Rogoff study that we cited on 1/15/09. Second, the insolvency of a nation’s banking system does not have effect upon the duration of the crisis. Third, the output loss to the economy during the period of the crisis is often major, around 5%/year on average.

The length of the crisis is a crucial determinant of output loss. Excerpting Table E of the study:

Table E: Average estimated GAP2 output losses per year of the crisis (per cent of annual
GDP)

Crisis length High-income Sample size

2 years or less 4.1 6

3-5 years 5.2 6

More than 5 years 5.6 5

All crises 4.9 17

The authors ask, why should banking crises last longer in developed countries? “In general, financial systems in developed countries would be expected to be more robust to shocks than those in emerging market countries…However, although crises in developed economies are likely to be less severe, initially, delay in resolving them is likely to increase sharply the long-run loss in output.”

So, to the findings of social science we add the following present uncertainties:

1) Unlike the national crises studied above, the present crisis is a problem of the financial system, extending world-wide. As in the 1930s, there is no historical basis to predict what will happen.

2) It is uncertain how long the U.S. will delay resolving this crisis; the longer the delay, the worse the economic output loss.

3) It is uncertain what the effects will be of fiscal stimulus and the efforts of government to get the economy functioning again.

What does all this mean? It means caveat investor. The Economist is usually optimistic, and does not usually make drastic systems observations. Its articles advocate this reform or that reform, but the April 23^rd cover is astounding. Against a Stygian backdrop, it shows a school of (optimistic) fish swimming right into the maw of an angler fish, a denizen of the deep. The editorial is of a similar mood:

…optimism contains two traps…The obvious trap is that confidence proves misplaced-that the glimmers of hope are misinterpreted as the beginnings of a strong recovery when all they really show is that the rate of decline is slowing…

Begin with those glimmers. Its easy to read too much into the gain in share prices. Stock markets usually rally before economies improve, because investors spy the promise of fatter profits before the statisticians document a turnaround. But plenty of rallies fizzle into nothing…

Even if that moment (of inventory reduction) is at hand, two other slumps are likely to poison the economy for much longer. The most important is the banking crisis and the purge of debt in the bubble economies, especially American and Britain. Demand has plummeted as tighter credit and sinking asset prices have exposed consumers’ excessive borrowing and scared them into saving more. History suggests that such balance-sheet recessions are long and that the recoveries which eventually follow them are feeble.

The second slump is in the emerging world…

Add all this up and the case for optimism fades quickly. The worst is over only in the narrowest sense that the pace of global decline has peaked. Thanks to massive-and unsustainable-fiscal and monetary transfusions, output will eventually stabilize. But in many ways, darker days lie ahead. Despite the scale of the slump, no conventional recovery is in sight. Growth, when it comes, will be too feeble to stop unemployment rising and idle capacity swelling. And for years most of the world’s economies will depend on their governments.

We think this is still the time to seek the preservation of capital rather than its enhancement. What is out there is not a placid state of risk, but true uncertainty. If you are years away from retirement, this might apply less to you because years of earnings growth will eventually dominate stock prices. If you are close to retirement, the initial values of your portfolio matter very much, because they will determine how you will live in the future. This is a time to be very careful. The above does not preclude our future investment in equities, but we would expect in return market valuations that would reflect lower than normal growth prospects.

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The housing debacle and the recent stock market rally illustrate that markets can, for a while, get quite detached from reality. As our article, “The Nature of Stock Market Equilibrium” discussed, markets fluctuate quite wildly around that equilibrium and error correct only very slowly (ρ = .15 out of 1). This means that short-term markets can be motivated either by excessive optimism or pessimism (greed or fear). We suggest this article by Pimco’s Bill Gross who discusses both markets and present fundamentals.

The French economist Léon Walras (Vohl-rah) observed that all markets grope for equilibrium (tȃtonnement). Less theoretically, they grope for reality, the process usually fueled by either excessive optimism or pessimism.

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The financial markets continue to rally under the assumption that the glimmers of recovery will become full-fledged growth in six (again that figure) months, a V shaped recovery. This assumes that that the administration’s incremental muddle through financial strategy in dealing with this crisis will be successful: even though market-based monetary policy is ineffective, the U.S. banking system remains loaded with at least around one trillion dollars of toxic assets (IMF estimates as of 4/09 have been increasing), and house prices continue to slide (but at a slightly decreased rate).

Is incrementalism the way to go? Paul Krugman succinctly writes in the 5/7/09 NYT, “…maybe we can let the economy fix the banks instead of the other way around.” He points out the danger, “…a muddle-through strategy will turn out to be a recipe for a prolonged, Japanese-style era of high unemployment and weak growth.” This possibility should be seriously considered in addition to fundamental system uncertainties. If this happens, the stock market will begin to price lower prospects for long-term growth at a P/E much lower than 18, where it is at present.

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Stock picking is generally a “green shoots of growth” enterprise, that presupposes the existence of markets; but this is a crisis of the financial system. A top-down view is therefore more useful to conceptualize and deal with this problem.

The April 09 IMF Financial Stability Report contains a Global Financial Stability Map (p.p. 2 or 3) that indicates, between 10/08 and 4/09, the risk appetite of investors improved; but macroeconomic risks, credit risks, and emerging market risks (especially in Eastern Europe) increased. The last increased notably.

The IMF has experience dealing with many financial crises, and this is its observation of the current one. “Without a thorough cleansing of banks’ balance sheets of impaired assets, accompanied by restructuring and, where needed, recapitalization, risks remain that banks’ problems will continue to exert downward pressure on economic activity.…Experience with addressing banking system crises suggests that the public sector should ensure viable institutions have sufficient capital when it cannot be raised in the market and to do so through a single up-front operation. Market participants are less confident to transact and invest where they see the risk of further, as yet unspecified, major policy interventions….Steps should be taken to encourage private sector participation in recapitalization to the extent possible under current market conditions. However, further bold steps are needed at this point to restore market confidence…”

There are other shoes to drop out there; and, to mix a metaphor, its time to press the reset button.

6/1/09 –

We keep a notebook of articles to help assess the pros and cons of investing in the stock market. After a period of no reasons, whatsoever, to invest in the U.S. stock market, the pro articles now appearing point to the facts that government has averted an economic collapse by keeping interest rates at zero, lending directly to the economy, and guaranteeing private debt. Summarizing the con articles, collapse has been averted at a cost: lower future economic growth that, we think, has yet to be factored fully into U.S. stock market prices. In the 5/27/09 NYT, a Deutsche Bank economist observes, “Anything that measures sentiment has improved. We’re not seeing it in the hard data , but seeing it in sentiment.” The article then continues, “And with unemployment projected to rise from 8.9 percent to as high as 10 percent over the next year, economists warn that consumers may lose that new found optimism in the months ahead.”

We try to predict because – as this crisis has amply illustrated – its necessary; and stock values, in any case, depend upon the functioning of markets. How is the study of economics useful? In a 5/24/09 NYT article, Harvard professor N. Gregory Mankiw discusses how the economic crisis has changed his teaching of introductory economics. Not so much, he writes. The principles of economics (supply and demand, efficient market outcomes, fiscal and monetary policy) remain. The study of financial institutions, whose failure is at the heart of the current crisis, is for more advanced courses. The article ends with the observation that “students should understand that a good course in economics will not equip them with a crystal ball. Instead, it will allow them to assess the risks and to be ready for surprises.”

Before the 2001 economic downturn, predicting the stock market effects of cyclical monetary policy was simple. The Fed raised interest rates to control inflation. The bond markets crashed, and so did the stock market. Then, the reverse was true. The economic response to Fed policy was at least directionally valid. With the advent of globalization and the migration of industrial (i.e. interest rate sensitive) production abroad, monetary policy became not too effective. In this 2008 crisis, monetary policy is even less so. Ben Bernanke’s 2004 paper titled, “Monetary Policy Alternatives At the Zero Bound,” is now relevant.

The S&P 500 has rallied to 943. What about the future? The effects of governments’ fiscal and monetary policies upon a globalized financial system will be very complex, and its banking problems are not yet solved. Thus Professor Mankiw’s observation is quite relevant; economics does not equip people with a crystal ball, but allows them to assess risks and to be ready for surprises. The now very complex national and international economic systems presents a problem for investors. Capitalist market economies create economic growth, but are unstable. Socialist economies, on the other hand, did not grow much beyond the basics, but were stable (stagnant). The present situation is probably a significant mix of the two, without yet the modulation of effective regulation.

The investing implication of this is low future earnings growth, however with a continuing risk of more specific problems as large imbalances continue to work their way through the economic system. It would therefore be a good idea to migrate up the balance sheet to also include medium-term corporate debt with high margins of safety, preferred stock, and maybe some inflation hedges. This economic crisis is causing, and might further cause, wealth destruction; it is advantageous to do some reasonable things to manage your risks. Marsilio Ficino, a philosopher (remember him?), described how to navigate the political turmoil of Renaissance Italy:

…remember there is this alternation of good and evil, so that good things ought not to be accepted without apprehension nor evil things endured without hope. Therefore we should rejoice in good things with moderation; and sorrow in evil things with even greater moderation.

From the past learn the present. In the present, as far as you are able, look about you at individual things and discern their end. You ought never to launch upon anything that has to be said or done in the present until, as far as possible, you have discerned its future….Finally, when in each action you have committed yourself humbly to God, and done everything in the light of reason…live at peace; and whatever follows accept for the best.

Marsilio Ficino

(1495)

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Why is rationality in the essentials likely to produce good results? It is because rationality results (if you think about how it evolved) in adaptive responses to the world. The following article contrasts two different approaches to dealing with the world. Also important is their two very different attitudes that make a difference in the long-run.

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Massive fiscal stimulus around the world has averted financial catastrophe, where anything could have happened. The May, 2009 Case-Schiller report indicates, however, that house prices continue to drop at a rapid rate. The housing crisis has unleashed large tidal forces that continue to operate in the economy. We think the financial crisis has diminished from a tsunami to a very high surf, possible to handle but with extreme care.

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In the above, we have suggested the advantage of buying medium-term bonds with high margins of safety. Ideally, you should buy individual bonds rather than a medium term mutual bond fund. The crucial reason is as follows: If you buy a number of specific bonds, say maturing five years out, their interest sensitivity will decrease to zero over that five year term. At current interest rates – which may be driven up solely due to government demand – and expected inflation, this strategy promises at least a real return on your capital.

7/1/09 -

The availability of credit and therefore future economic growth is still a problem. The banking system, accounting for around 30% of the credit granted to the private economy, has to earn back capital before increasing its lending. That could take more than a couple of years. Increase in total credit also depends upon the securitization markets.

Necessary government action has bought time; but fiscal policy alone cannot expand the private economy. On 6/8/09 the economist, Paul Krugman, addressed the London School of Economics. He pointed out that past recoveries: in Sweden, East Asia, and Japan were led by export booms – an alternative not available to the world economy in a Keynesian liquidity trap, with interest rates at the zero bound. Furthermore, 1) In a liquidity trap, monetary policy is not effective. 2) Fiscal policy can buy time while households deleverage over the next ten (sic) years and household demand begins to revive. A consumer boom is why the U.S. economy did not lapse into a depression once the fiscal stimulus of W.W. II government wartime spending disappeared. 3) Maybe the development of new technologies will increase private investment.

How will this all end? He has no idea; but what could happen is years of low growth, a global version of Japan’s lost decade without the prospect of an export recovery.

Alternatively, it has been argued that the unprecedented amount of monetary creation around the world to combat depression will create inflation one or two years hence. The unique circumstances of this downturn: a damaged credit system, very lowered capacity utilization, and deleveraging all point to the exact opposite. At present, monetary creation simply ends up as increased excess bank reserves, government bond purchases, and increased financial asset prices not affecting the real economy after its initial effect. The transmission mechanisms (we have an engineering background) linking credit creation to the real economy are bank lending and securitization. Bank lending will not create inflationary pressures in the economy due to the above. An unlikely large increase in non mortgage securitizations *, that unfortunately reversed, could. We’d watch that along with future Fed policy.

These are the reasons to add medium term bonds to your portfolio, and maybe to also hedge slightly against inflation. Perhaps this analogy is apt. Sustainable economic growth is like good health. Unfortunately, the patient has suffered an extreme trauma. Not just one thing has to be fixed, but a number of systems. The credit system has to be repaired, the regulatory system has to be overhauled, and the economy has to be restructured – emphasizing industry and the core competencies that produce exports -, and debt reduced. Recovery is possible, but there is no miracle drug.

* This table tells the story of the credit crisis; the last line has to be annualized. Non-mortgage securitizations were a major percentage of GDP. In 2006, these securitizations peaked at 5.7% of nominal GDP.

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So, what’s the way out? In the 6/28/09 NYT Thomas Friedman writes, “…the country that uses this crisis to make its population smarter and more innovative - and endows its people with more tools and basic research to invent new goods and services – is the one that will not just survive but thrive down the road.” This is the key to get us out of this crisis, but its going to take well-focused effort and time.

The alternative to creating sustainable economic growth is for government to keep spending unsustainably. That’s a very bad idea because it will greatly increase the deficit, eventually pulling down the U.S.’s credit abroad.

8/1/09 –

The U.S. stock market is currently expecting cyclical growth in the economy rather than a secular change. GDP growth should increase employment, that will in turn further increase GDP in a mutually reinforcing cycle. But the 7/20/09 Bloomberg reports that Larry Summers, head of the administration’s National Economic Council, thinks that the U.S. economy’s growth next year is “very much in doubt.” The article then goes on, “Summers’ remarks reflect indicators that suggest the deepest recession in half a century may be ending with little momentum in private spending.”

Why this is so can be seen from the following. We track two major sources of credit:

Loans and Leases in Bank Credit continue to decrease. This is the current state of bank credit. For the U.S. economy, the IMF considers a 1% growth of credit during a recession extremely stringent.

Loans and Leases in Bank Credit (billions of dollars) ( Seasonally Adjusted, Fed Reserve Call Report)
Dec. 2008	Jan, 2009	Jun 17	Jul 15	Change from 12/08
7255	7185	7094	6991	-3.63%

Furthermore, the volume of U.S. non mortgage securitizations as of Q2’09 is not rebounding strongly. The GDP multiplier of this form of non-bank financing is theoretically infinite. Catastrophe has nonetheless been averted by hundreds of billions of dollars of government spending; but this spending – that Mr. Zoellick of the World Bank calls a “sugar high” - will not by itself restart economic growth. The U.S. economy will have to undergo a secular change from less consumption to more industrial production; and the credit markets will reflect that fact, allocating less credit towards the former.

Analysts started spying the “green shoots of recovery,” and then the market rallied on the fact that the deterioration in the economy seemed to be bottoming out on the way to growth. Given the above, however, bottoming out will not necessarily lead to future growth. The long run stock market is a weighing machine rather than a voting machine. If any significant group of analysts suddenly spot yellow weeds in the real economy, the current stock market rally will reverse because at a P/E of 17+, the stock market has already priced in a substantial amount of earnings (and therefore revenue) growth. That, by the way, includes an estimate of positive financial company profits over the next few years despite fact that maybe only one-third to one-half the bad debt has been written off.

Future economic growth? To get a sense of the current situation, we compared the revenue changes of five large cap companies, whose stocks recently rallied:

	FORD	AT&T	INTEL	STARWOOD HOTELS	CAT
Revenue Changes (Mar, 2008-2009)	-45.4%	-.6%	-26.6%	-28.6%	-21.8%
Quarter of Expected Positive Revenue Growth Comparisons	4^th Q 2009	1^st Q 2010	1^st Q 2010	1^st Q 2010	4^thQ 2010

All the above companies had lower revenues in the first quarter of 2009 compared with 2008. We also compared their Value Line^© quarters of first estimated revenue growth. Estimates seem to be unfolding in a typical cyclical fashion; but government financing growth has replaced private credit system growth. As the defense industry illustrates, it is certainly possible for private companies to make money in businesses where the government is the main customer. But, the price to be paid for this massive and necessary government intervention in the private economy is lower economic growth * and therefore lower stock earnings multiples. The process of replacing government credit with private credit will likely be much more easily said than done. Furthermore, the U.S. economy has to restructure itself to emphasize export rather than consumption, a scale of adaptation that the 7/25/09 Economist calls “daunting.”

Economic rational expectations assumes that relevant information is always reflected in the markets without bias; but the world is structurally very complex. In the long run, the stock market is a weighing machine rather than a voting machine. But in the short run, there is a lot of economic voting behavior that qualifies economics and its error-correcting markets as a social science rather than as mathematical physics.

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We are normally value investors, and don’t like to predict unless we have to; but stock values will be stagnant unless there is a catalyst of economic growth. Since this financial crisis is macroeconomic, it is necessary to consider macro matters and how they might trend. The 7/27/09 Bloomberg was skeptical of market estimates. According to 1/9/09 data, “Forecasters predicted fourth-quarter profits would fall 19.7%…according to consensus estimates compiled three days before the earnings season began. Instead, earnings plummeted 61%, the biggest decline since at least 1998…” As this and, of course, the subprime meltdown illustrate, market estimates can be wildly wrong.

A real estate developer once said that before doing projects, he had this “theory,” so to speak. Markets at the collective level have this “theory” about the future that may or may not turn out to be correct. This 7/28/09 article in the Wikipedia is an excellent discussion about when groups of people reach correct decisions and when they do not.

A product of the Enlightenment, the U.S. state was designed to produce rational decisions. It was designed with strong built-in error correction mechanisms. Thus it has been accurately said (usually with humor) that in moments of crises, “The Republic will survive.” Madison’s doctrine of the separation of powers created a series of institutional checks and balances, very neatly encompassing Surowiecki’s distinctions between a wise crowd and an irrational one. In fact, the Federalist Papers (1787-1788) can be regarded as one long discussion how the social institution of government could arrive at rational and therefore adaptive decisions.

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On 8/7/09 the Bureau of Labor Statistics reported that job losses had slowed to 247,000, the first improvement from the loss of 321,000 during September of last year, the month of the Lehman and AIG problems. The economy appears to be bottoming out, but the S&P is now around 1000. The P/E of the stock market is around 18X earnings, a valuation level that assumes a very substantial V shaped earnings recovery in the near future. The crucial question, that our readers can answer for themselves, is whether the future economy will look like a “L” or a “V”.

Our general sense, to observe what’s really happening, is that there are add: presently few readily identifiable sources of future growth in the economy, due to the large restructuring necessary away from consumption and the continued lack of credit. If this is the state of affairs, then the P/E of a low-growth stock market should be somewhat around 14X earnings and…

In the long run, the U.S. has to save and export more. Now the economy just has to come up with the products, which is more complicated.

9/1/09 –

The S&P 500 increased to 1026 on 8/21/09. The crucial question for long-term investors is whether or not the current stock market level is sustainable.

The stock market has been buoyed by hopes for future economic growth. Economies around the world appear to be stabilizing, Massive government spending has had its effect, averting worse panic and a very severe downturn. S&P projects an increase in S&P 500 operating earnings from $54.40 in 2009 to $73.05 in 2010.

To answer the above, we ask is how an investment in the stock market compares with the bond alternative:

1) Our usual measure of stock market valuation, around which the stock market in the long-term error-corrects, is the ratio: Bond Yields/Stock Earnings Yields. This measure does not specify future economic growth, implicitly assuming the 7.55% nominal growth between 1968 and 1999. By this measure, the stock market is greatly undervalued. The ratio is .98, versus a normal level of 1.50 and a maximum level of around 2.20.

2) Analyzing (the way they teach in business school) from the standpoint of dividends rather than earnings. The current level of the S&P 500 is 1026. We use the Gordon Model of stock valuation to calculate, not what the level of the stock market ought to be, but the implicit rate of return the current S&P 500 will reward long-term investors. We assume a lower growth economy. S&P expects 2009 dividends to be $24.60, we assume real earnings growth of 2% + 2% inflation.

Investment rate of return = S&P 500 dividend yield + nominal growth in dividends = 24.60/1026 + .04 = .064 = 6.4%

If we compare that investment return for stocks against the current long-term corporate bond yield of around 5.4%, that 1% risk premium is insufficient given the risks. The U.S. economy must shift from less consumption to more export; consumers have to increase their savings rates; structural problems with the financial system have to be solved; and the Fed has to transition the economy from government to private credit. We track the Fed’s “Loans and Leases in Bank Credit.” Bank lending continues to decrease.

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For those interested in financial structure - the decreases in bank lending and now securitizations are crucial factors associated with the decrease in economic growth. Using data from the moderately deep recession of 1990-1991, we investigate the overall picture. The following table illustrates that there was a very close relationship between the change in bank lending and the change in real industrial capitalization utilization, also S&P 500 operating earnings.

Year	1990	1991	1992	1993
Yearly Change Total Loans and Leases	-1.66%	-5.06%	-3.53%	3.55%
Capacity Utilization	81.4%	79.3%	79.2%	82.9%
S&P 500 Op. Earnings	22.65	19.30	20.87	Sources: FDIC, Federal Reserve, S&P 26.90

This chart from the FDIC illustrates the quarterly changes in lending from the recession of 1990. Credit matters.

How do the above affect the short-term level of the stock market? A major 30.6% gain of large cap stocks in 1991 was affected by the (justified) expectation of an economic rebound. The 10.6% four year cumulative annual return of large cap stocks was aided by an increase in operating earnings and, most crucially, by a large 25% decrease in long-term AA corporate bond rate.

Year	1990	1991	1992	1993
Stock Market Yearly Return	-3.2%	30.6%	7.7%	10.0%
Cumulative Yearly Stock Market Return from 1990				10.6%
L.T. AA Corp Rate	9.8%			Sources: Ibbotson, NYT 7.3%

At a P/E of 18, the current stock market rebound contains both the relief that the economic system has not fallen apart (which is thankfully true) and the expectation of high future earnings growth (that we think is not justified). The data above also shows:

1) The 2009 recession with a current industrial capacity utilization of 68.5% is extraordinarily deep, making a large future economic rebound less likely because the problems are also structural. Judging also from the recession of 1990, bank lending and therefore economic growth is likely to be affected for a long time.

2) The present AA long-term bond rate of 5.4% cannot continue to decrease. Given current deficits, investors can best expect only that it not increase.

3) The current market rebound is partially justified by the relief that the financial system has not fallen apart, but is unjustified by the likelihood of low economic growth. We note that in 1933, the U.S. stock market increased by 54%. That large stock market rally was due to the fundamental of a U.S. investment boom.

Given current markets, we would wait for the stock market to drop somewhat before investing in stocks (unhedging our portfolio).

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An article published in the 9/4/09 Financial Times cites a stock market report from Morgan Stanley concerned with, “the combination of fiscal tightening and further deleveraging by consumers and banks. It is this cocktail that will condemn the stock market to years of range bound trading.” We think, more specifically, that the “new normal” economy will result in lower growth and lower stock P/Es. It is therefore important not to overpay for growth.

add: What’s happening to the economy in the shorter term? This economic view differs from that of the stock analysts. According to the 9/8/09 Bloomberg, 1500 analysts believe that S&P 500 profits will rise by 25% next year, 10.9X faster than the expansion of GDP forseen by 53 economists surveyed. The ratio of estimated Income Growth/GDP growth is the highest on record based on data going back 60 years. A company level view would go something like this: companies have cut expenses at unprecedented rates, and thus have a great deal of operating leverage to take advantage of an economic rebound that always occurs. Profits are then going to roll in.

Our view is that extensive (add: or ill-designed) government intervention in the economy can stabilize the situation, but cannot produce real (add: long-term) growth. Why is this so? Leaving aside all ideological considerations, what is the economic effect of a pure fiscal policy? We go beyond Keynes to the France of 1789, immediately after the beginning of the French Revolution. In Fiat Money Inflation in France (1896), Cornell historian Andrew Dickson White wrote:

The vast reforms of that period, though a lasting blessing politically (our note, the author’s judgment), were a temporary evil financially. There was a general want of confidence in business circles; capital had shown its proverbial timidity by retiring out of sight as far as possible; throughout the land was stagnation. (The politics was another matter.)

Statesmanlike measures, careful watching and wise management would, doubtless, have long led to a return of confidence, a reappearance of money and resumption of business; but these involved patience and self-denial and, thus far in human history, these are the rarest products of political wisdom….

There was a general search for some short road to prosperity: ere long the idea was set afloat that the great want of the country was more of the circulating medium; and this was speedily followed by call for an issue of paper money….

It would be a great mistake to suppose that the statesmen of France, or the French people, were ignorant of the dangers of issuing irredeemable paper money. No matter how skillfully the bright side of such a currency was exhibited, all thoughtful men in France remembered its dark side. They knew too well, from that ruinous experience, seventy years before, in John Law’s time, the difficulties and dangers of a currency not well based and controlled. They had then learned how easy it is to issue it; how difficult it is to check its overissue…

(In April, 1790 The National Assembly authorized an issue of four hundred millions of livres in paper money, or U.S. $936MM presently, a massive sum relative to the size of the economy at that time.) This sum – four hundred millions, so vast in those days – was issued in assignats which were notes (eventually used as cash) secured by a pledge of productive real estate and bearing interest to the holder at three per cent. No irredeemable currency has ever claimed a more scientific and practical guarantee for its goodness and for its proper auction on public finances. On the other hand, it had what the world recognized as a most practical security, - a mortgage on productive real estate of vastly greater value than the issue. On the other hand, as the notes bore interest, there seemed cogent reason for their being withdrawn from circulation whenever they became redundant.

The first result of this issue was apparently all that the most sanguine could desire: the treasury was at once greatly relieved; a portion of the public debt was paid; creditors were encouraged; credit revived; ordinary expenses were met, and, a considerable part of this paper money thus been passed from the government into the hands of the people, trade increased and all difficulties seemed to vanish. The anxieties of Necker, the prophecies of Maury and Cazalès seemed proven utterly futile. And, indeed, it is quite possible that, if the national authorities had stopped with the issue, few of the financial evils which afterwards arose would have been severely felt; and four hundred millions of paper money then issued would have simply discharged the function of a similar amount of specie. But soon there came another result: times grew less easy; but the end of September, within five months after the issue of the four hundred millions in assignats, the government had spent them and was again in distress. (This describes Robert Zoellick’s “sugar high.” *)

The old remedy immediately and naturally recurred to the minds of men. Throughout the country began a cry for another issue of paper…

* Schama (1989, p. 185) writes, “In 1795, the total value of France’s trade was less than half what it had been in 1789; by 1815 it was still at about 60 percent. The momentum of economic and social change in France only picked up as the Revolution and the military state it created in its wake disappeared.”

* This leads to the interesting question of when fiscal policy is effective to kick-start the economy and when it is not. It is likely effective only when combined with an effective monetary policy. In an IMF paper Baldacci et al. write, “One of the key findings of the literature is that fiscal responses lead to sustained economic recoveries after the crisis only when financial sector’s vulnerabilities are addressed without endangering fiscal sustainability (IMF, 2009a). Crisis resolution measures generally entail costly government restructuring of private sector’s balance sheet, including of the financial sector, which can have a lasting impact on public debt levels.”

A major problem in this financial crisis is that the U.S. has not yet restructured its financial system; thus government expenditures will not result in the GDP multiplier produced by private lending. The money the government supplies will simply end up in the banking system, as excess bank reserves, and not be re-lent to spark trade and commerce.

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To summarize: long-term investment factors and short-term economic factors argue for a lower stock market. Non-fundamental and short-term investment factors (add: for instance, liquidity provided by the government) result in current market prices.

10/1/09 -

The S&P 500 closed on 9/30/09 at 1057. The symbolic economy, the markets, has rallied in the expectation of a rapid recovery in the near future. Reality, however, is going to be more difficult. Credit is necessary for modern economies to grow. The above comment shows that gross bank lending picked up after a long delay in the 1990 recession. But updating our 4/8/09 posting, current bank credit extended net of loan and lease losses has decreased substantially. This recession is extraordinarily deep, the result of structural rather than cyclical problems. We do not therefore expect a simple cyclical bounceback.

Loans and Leases in Bank Credit (Federal Reserve Call Report, Seasonally Adjusted, Including Allowances for Loan and Lease Losses)

Recession Event  Peak to Trough

1973  - .66%

1980  - .58%

1990  -1.15%

2001   - .39%

2008   -6.66% (10/31/08-9/16/09, sic)

Bank lending comprised around 30% of the total private credit extended to the economy. We await data on new non-mortgage securitizations for the third quarter ending in September; preliminary estimates indicate that figure will be a lot less than in 2007. Henry Kaufman (2009) points out that financial institution deleveraging also results in fewer securitizations because the banks have a decreased ability to hold inventories.

Although the financial markets have improved, private credit growth is not financing the real economy, the government currently supplying the gap. The private financial system still needs to be recapitalized in order to function. The stock market should reflect the economic realities of increased savings, decreased consumption, and deleveraging – eventually. Since the financial system is still in the ICU*; the way to preserve, and possibly enhance, capital is to remain cautious and not make large mistakes.

* The length of this crisis now exceeds two years. Is all forgiven? Not quite. The 9/30/09 WSJ cites an IMF report, writing “projected total losses in the banking sector specifically will reach $2.8 trillion….Of that amount, the IMF said, banks globally have written down $1.3 trillion and have additional potential losses of $1.5 trillion facing them.”

The Rogoff study cited on 5/1/09 places the average length of financial crises of around four years. Professor Rogoff said, so far, this financial crisis has proceeded exactly on track. Actually, we think that’s good news because, unlike some other crises, this crisis has struck in the middle of the world’s financial system rather than at its periphery. The massive infusion of government money has kept things from getting a lot worse; but there are side-effects, among them lower growth.

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The most recent data on Non-mortgage U.S. Asset Based Securities issuance indicates only a degree of recovery in the third quarter of that market. The following volume of securitizations shows that the overall consumer credit situation is beginning to improve, although securitizations will be clearly way below the level of 2007.

Total Non-Mortgage Securitizations

(billions of dollars)

2007 2008 2009

 9 Months YTD 436.4 136.0 118.1

 3^rd Quarter 86.0 20.1 48.0

Most crucially, we note that government TALF guarantees continue to support this market. The 7/2/09 Reuters quotes a securitization attorney, “I’m just looking at the market and not getting a sense that it could survive anywhere near this way currently, without continued support from TALF.” The root of the word “credit,” as we have been noting, is the Latin word credere, to believe.

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We recently attended a value investing conference. The speaker noted that in the stock market, there have been 33 bubbles (we didn’t catch in how long). and said how one handles a bubble beats years of stock-picking. He also quoted extensively from Keynes’ noted and notorious Chapter 12 of the General Theory, on the formation of long-term expectation. These are our thoughts about the relevance of the conference and of markets to investors:

1) Most people by temperament and experience are either value investors in companies (the minority) or traders in markets. Value investors are usually indifferent to general markets; but value investor risk management now defines market risk, not as statistical variance, but as the possibility of a permanent impairment of capital.

We think that taking on additional risk (defined as variance or beta) was a curious idea, when the financial system was truly on the brink. *

2) This website, with its discussion of markets, lends itself also to market timing and other primarily market oriented investment strategies. But that is not how we consider markets. Our analysis of the economic system gives us an idea of the state of the financial system and also (approximately) when stock values might appear. We buy a stock when it offers value and sell when it becomes overpriced. The speaker defined Quality as companies with low leverage, high return on capital, and stable business prospects; about 25% of the S&P 500 can be so classified. He expects that a quality growth stock strategy should grind through other strategies in the next few years of low economic growth. We would agree.

3) The speaker thinks the present stock market is not considering at all the economic fundamentals, responding only to the speculation and herd behavior occasioned by low interest rates and stimulus.

* add: This implicitly makes an utterly crucial distinction between investing behavior and gambling behavior. Facing the very real possibility of a systems meltdown, an investor would look at the fundamentals and seek to protect himself to the extent possible. A gambler, seeing this crisis as the last turn of the roulette wheel, would go all in. The abstract paradigm of modern risk management that life is a gamble on some statistical model affects capital formation, employment, and the trade balance of the real economy - about which the next article shall comment.

We assume the financial system will not fall apart; and that events in the macro economy will eventually result in U.S. stock market values, resulting from some market decline.

10/16/09 -

The level of the U.S. stock market is supposed to reflect the level of economic wealth. This paradoxical stock market has rapidly increased in value although the real economy has dropped exceptionally, for instance: the labor markets (unemployment 9.8%), house prices (obvious), commercial real estate (with the values of many projects cut in half), and net private investment (2^nd quarter, 0.1% of GDP).

The excess liquidity supplied by government has found its way, not into the private capital markets to finance growth, but into the stock market that now implicitly prices in a sustained and rapid economic recovery. Manufacturing inventory investments, however, reflect the real expectations of company managements. We compare 2008 inventories with 2009 inventories for several large industrial companies:

Third Calendar Quarter Manufacturing Inventories

(millions of dollars)

GE Intel Cisco¹ Ford (2^nd Quarter)

	2008	2009	2008	2009	2008	2009	2008	2009
Total	14700	13100	3398	2390	997	890	14046	7447
Change		-10.9%		-29.7%		-10.7% ^2		-47%

¹ Cisco’s purchase commitments to its contract manufacturers dropped by 21% in the same period.

² add: On 11/4/09 Cisco reported quarterly sales of $9 billion, down 12.7% from the previous year. The company, however, expects improvement in 2010; and its financial decisions are consistent with this assumption.

Manufacturing company managements are less optimistic about the near future of their businesses than the stock market. In this article, Mohamed El-Erian of Pimco suggests that what matters to the economy and ultimately to markets is levels. Determining stock price levels justified by sustainable economic fundamentals is a primary value investor interest. In a more general sense what matters now is the restructuring of balance sheets.

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“Since Sept. 1 directors and executives at publicly traded U.S. companies have sold $40 worth of shares for every $1 in purchases (these figures probably don’t account for vesting stock options as purchases, but the following comparison is valid). That compares with $22 in sales for every $1 buy from March through August. Insider selling hasn’t been this high since the downturn began at the end of 2007….”

Business Week; October 26, 2009

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This leads to a general point, “How do you handle complexity,” whether in macroeconomics (could this financial crisis have been predicted?) or in political science (what is an effective strategy in Afghanistan?). Extensive academic research has shown that at the general level, the behavior of complex systems can’t be predicted. But scratch, just slightly, below the systems level; the basics of life and business become evident:

1) Could the Financial Crisis of 2008 have been predicted? Of course. All any investor needed to do was to look a couple of levels below the abstract Gaussian Copula to see the junk lending that quantitative finance enabled, producing subprime loans that were certain to default and the high leverage that increased systems vulnerabilities.

2) What’s an effective strategy in Afghanistan? Afghanistan can’t be dealt with only at an altitude of 16,000 feet (the cruising altitude of a Predator drone). The key question is how you handle the deeply unsettled Pashtun tribes whose territory covers both Afghanistan and Pakistan, a country that has nuclear weapons. A series of articles by David Rohde, a NYT correspondent, abducted into the tribal area reveals a mosaic of warlords, fanatics (some foreign), fiefdoms, and drugs. The Taliban are not, as some accounts would have, simple farmers that wish merely to be left alone. An effective U.S. strategy, that is evolving, would be more akin to pacifying the turf disrupted by the warfare of large gangs.

3) What’s happening in the U.S. stock market and economy? To quote a 10/19/09 NYT article about newspaper publishing and to reason only somewhat by analogy:

…while the McClatchy Company’s advertising revenue fell 28.1 percent in the third quarter, it was not as bad as the 29.9 percent it dropped in the first six months. O.K., not so great, but with net income of $23.6 million in the quarter, it was a huge improvement over the $4.2 million a year earlier.

The reason the balance sheet cleaned up so nicely? The company eliminated more than 30 percent of its work force in the 18 months.

What this suggests is that we’re facing a paperless recovery wherein old-line content companies need to continue to slash in order to stay ahead of what looks to be a broad secular decline.

We think the new normal will be lower economic growth as the economy restructures. 

11/1/09 –

The S&P 500 closed at 1036. Although the real economy grew at an annualized rate of 3.5% in the third quarter, as a % of GDP however, the actual quarterly improvement was only 3.5%/4 = .88% of GDP, with effective economic consumption boosted by both auto and new home buyer government subsidies. In the present economic context, these are not investments for the future. The stock market, however, is becoming aware of a new reality for which the following is a continuing sign:

Loans and Leases in Bank Credit (Federal Reserve Call Report, Seasonally Adjusted, Including Allowances for Loan and Lease Losses)

Recession Event  Peak to Trough

1973  - .66%

1980  - .58%

1990  -1.15%

2001   - .39%

2008   -7.97% (10/31/08-10/21/09, sic)

We would like nothing better than to call an all clear and go back to the business of looking for stock market gems, often in the rubble. But we think that economic problems are likely to continue; next are the commercial defaults in real estate loans and private equity LBOs. Economist James Galbraith says that the Administration is seeking to recreate the economic conditions of 5-10 years ago, when all seemed well. But misinvestment and excessive leverage have finally caught up with the U.S.; its really time for policymakers to start planning how to adapt to the more competitive world that globalization has created.

Our readers may note an apparent conflict in political philosophy between that sentence and the last sentence above, but we are talking about two different levels of analysis. Free markets practically require appropriate regulation and some direction at the right time.

11/8/09 –

On 4/8/09 the S&P 500 closed at 857. At that time, we made a decision not to chase the developing market rally because we considered the fundamentals of both the financial system and the economy very fragile. On 11/8/09 the market closed at 1096, an increase of 28%. We have naturally reviewed our reasoning, asking whether the economic fundamentals point towards growth rather than to a possible stabilization at a low level. Historically severe decreases in lending, and therefore private sector credit creation, and very high levels of job losses are the signs of a financial system and economy with large structural problems. We don’t think they are merely the lagging indicators of a cyclical recovery.

Central bank liquidity increases have resulted in large stock market price increases. The tide of money arguments justifying these increases are several:

1) The U.S. stock market is correlated with the foreign stock markets, so an increase in the latter will result in an increase in the former. The correlation argument, as we shall later discuss, is one of the worst because financial correlations aren’t stable.

2) The trend is your friend (until it isn’t).

3) Money is money; whether it results from a loose monetary policy, a loose fiscal policy, or both.

The problem with the tide of money argument is that it is short term, not relating to the economic fundamentals, and thus a justification of excesses. Real estate developers are known to build, simply because the money is available to finance their projects; and some investors likewise invest for the same reason. If we were asked why we might have invested in the stock market in April, we could only have said it was because of the liquidity in the financial system. But Charles Prince, former CEO of Citigroup said, “As long as the music is playing, you’ve got to get up and dance…We’re still dancing.” This comment will spare our readers the subsequent details.

12/1/09 -

The fundamental present value model of stock market valuation assumes that a stock’s price is equal to the future stream of dividends, discounted at the investors’ required rate of return. There are three variables in the model. By making reasonable assumptions about two of them, it is possible analyze stock market growth expectations; assuming that investors are always rational. Actual stock prices are currently driven by a tide of liquidity generated by the central banks. The following analysis, assuming investor rationality, is however useful:

Assume the following: 1) That the long-term required rate of return for stocks is 2% above the yield to maturity of high quality long-term corporate bonds. Since the latter are currently around 5%, then the investor required rate of return for stocks is 7%. 2) S&P 500 dividends for 2009 are estimated at $24.60, that figure having dropped by 13.3% since the peak in 2008. If these are so, then the remaining term is assumed economic growth.

Assumed Economic Growth Calculated Value of the S&P 500

New Normal 2% real + 2% inflation	853
Normal 3% real + 2% inflation	1292

We make the New Normal assumption of low U.S. economic growth because of the factors mentioned on 11/8, also the necessary restructuring of the U.S. economy to reduce consumer debt and increase exports.

The valuation of the U.S. stock market is currently way above its now very likely fundamental of low growth. Value Line estimates the appreciation potential of the 1700 stocks it follows. It estimates a profit potential of only 55%, compared with a level of 185% on 3/9/09 and a level of 35% at the market high on 7/13/07. To earn a 7% market rate of return, we would be much more comfortable investing in stocks with the S&P 500 between 800-900. We choose a range because markets are, at best, imprecisely error-correcting.

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We suggest this NYT article that summarizes the economic reasons why we remain cautious.

So, why have stock market prices increased? The reasons are technical rather than fundamental. In a 12/4/09 WSJ article, “Near-Zero Rates Are Hurting the Economy,” economist David Malpass writes, “Wall Street will threaten a tantrum if the Fed even thinks about (raising short-term interest rates). The Street utterly loves the Fed’s largess, earning massive profits from trading unstable currencies, the carry trade (borrow short-term dollars near zero, buy longer-term assets abroad), and the high-margin process of transferring America’s (our note: borrowed) capital abroad. The hitch is that there isn’t much trickledown to normal jobs and small businesses from the sophisticated, zero-rate arbitrage that is propelling asset prices every higher.”

This website is now about (short-term, inaccurate) markets. The asset bubbles that the Fed is creating have little to do with the real economy; and in the medium or even short-term, the bubbles will collapse due to the unwillingness to recapitalize the banks (let them slowly earn out their loan losses- which they will do by zero-interest rate arbitrage in the markets rather than by lending). In the U.S., the excess liquidity supplied by the Fed is mainly being channeled to the symbolic financial economy rather than to the real economy.

We aren’t going to do stock trading because we really don’t think that way, and most of our readers are long-term investors rather than technical traders.

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add: In Security Analysis, Graham and Dodd seek to discourage what is now short-term quantitative investing, pointing out, “ …in highly dynamic economies there is no convincing reason for anticipating the maintenance in the future of some fixed (or given) relationships between stock prices and either an individual economic series or a composite index representing a number of series – irrespective of the duration of the historic support.” So much for unconditional financial engineering.

Regarding stock trading, “…success in trading is either accidental and impermanent or else due to a highly uncommon talent.”

Provided the financial system is stable enough, the authors offer this very useful perspective, “Long-term market considerations interest the investor, of course, because they are fundamentally identical with long-term value considerations.”

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